International Financial Management

Japanese investors, like Mrs. Watanabe in Chapter 2, have faced perennially low Japanese yen interest rates for years. They consequently have found high-yielding bonds denominated in Australian and New Zealand dollars quite attractive. More recently, retail aggregator accounts have been introduced that allow private Japanese investors to speculate in foreign exchange markets using forward contracts. A recent study reports that the retail market represented over $400 billion in daily trading volume in 2014. With the sudden lifting of the floor on the Swiss franc relative to the euro in early 2015 and the major appreciation of the franc that followed, a number of retail trading firms went belly-up with losses for retail investors. More regulation of this sector is expected to protect retail speculators, perhaps from themselves.

This chapter examines how investors quantify expected returns and risks associated with speculative foreign exchange investments. If an investor chooses not to hedge (or “cover”) the exchange risk on a foreign money market investment, the return is uncertain and will be high if the foreign currency appreciates or low if the foreign currency depreciates. Our discussion of uncovered investments in the foreign money market uses some basic statistical methods that are commonly used to explain empirical evidence about investment returns in all asset markets. The Appendix to Chapter 3 and Appendix 7.3 in this chapter provide the necessary background.

Speculating in the Foreign Exchange Market

Uncovered Foreign Money Market Investments

In Chapter 6, we examined covered foreign money markets investments and found that if interest rate parity is satisfied, the domestic currency rate of return from investing in a foreign money market and covering the foreign exchange risk is the domestic currency interest rate. What happens if an investor does not cover the foreign exchange risk? Let's look at an example.

Example 7.1 Kevin Anthony's Uncovered Pound Investment

Recall the situation in Example 6.2 in which Kevin Anthony, a portfolio manager, was considering several ways to invest $10,000,000 for one year.